Economies of Scale

Economies of Scale. A firm experiences EoS when long-run average costs fall as output rises.

A larger firm becomes more productive and lowers average costs in the long-run through economies of scale. Economies of scale makes a firm’s short-run cost curve shift down in the long-run.

Remember the short-run is that period of time in which at least one factor of production is fixed. All factors of production are variable in the long-run.

Long-Run Average Cost Curve

A firm experiences (internal) economies of scale if long-run average costs (LRAC) fall as output rises.

A firm remains on the SRAC curve in the short-run because at least one factor of production is fixed. Let’s say the firm’s only fixed factor is its building. A firm can vary all the factors of production in the long-run, move to a larger building, become more efficient and move onto a lower SRAC curve. After some point though, the next building the firm moves to is now too large to use efficiently so it moves onto a higher SRAC curve. An infinite amount of SRAC curves can be drawn and combined to make the LRAC curve. The LRAC curve is the envelope of all the SRAC curves. LRAC shows the minimum cost in the long-run for each level of output.

Returns to Scale

EoS: LRAC falls as output rises, the firm is benefiting from economies of scale. A.k.a. increasing returns to scale, a doubling of inputs leads to a more than doubling of output.

MES: the LRAC has reached its minimum point, the minimum efficient scale (MES), the minimum scale to fully benefit from economies of scale.

CRS: LRAC is constant as output rises, the firm is experiencing constant returns to scale. A doubling of inputs leads to a doubling of output.

DEoS: LRAC rises as output rises, the firm is experiencing diseconomies of scale. A.k.a. decreasing returns to scale, a doubling of inputs leads to a less than doubling of output.

Examples of Economies of Scale

A larger firm becomes more productive and lowers average costs for a number of reasons:

⦁ Technical Economies. As a firm expands it can buy specialist machinery to use in its production process. Using specialist machinery to produce a larger quantity increases efficiency so average costs fall. Also, as a firm expands there is more scope for labour specialization. Workers can be given specific roles to stick to in the production process, become more efficient and thus reduce average costs. Moreover, the ‘Law of Increased Dimensions’ states that a doubling of height and width of a building leads to a more than proportionate increase in its cubic capacity. The Law of Increased Dimensions means that a firm can benefit from increasing returns to scale (this is particularly useful in the airline, shipping, transportation and storage industries).

⦁ Managerial Economies. As a firm grows it can employ specialist staff to increase efficiency. Procurers (specialist buyers) can be employed to reduce the firm’s input costs. Managers can be employed to manage, motivate and/or supervise workers to increase labour productivity and lower unit labour cost. Accountants can be employed to minimize taxes and optimally deal with the firm’s profits and savings. Receptionists and IT staff can be employed to improve communication networks.

⦁ Financial Economies. As a firm grows it becomes more profitable and successful so it becomes less risky, has a higher credit worthiness so it can obtain larger and quicker loans and at a lower interest rate.

⦁ Marketing Economies. As a firm grows it can spread its advertising costs over its larger output. Additionally, the larger firm may gain some monopsony power to be able to bulk purchase and negotiate discounted prices for its inputs.